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Pulp fiction

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Around two years ago iconic paper and pulp conglomerate Sappi – amidst worried outcries from a number of market commentators – forked out R9bn to buy four mills.

It was a big deal, by any standards. The price tag of R9bn – at the time – was roughly 40% of Sappi’s market capitalisation. As things stand today, the deal’s value is now half of Sappi’s market capitalisation (around R18bn at close of business on the JSE on Tuesday).

A standing joke at the time was that Sappi [JSE:SAP] was buying mills just to shut them down. That joke has fallen a little flat with Sappi currently closing down one of the acquired mills and almost certain to shut down another shortly.

Are we looking at one of the most costly corporate forays undertaken by a JSE listed company in the last two decades? While Finweek always stresses that everything should be viewed over the longer term, there’s enough evidence to suggest that Sappi – which has a large contingent of retail shareholders – is going to battle to quickly extricate itself from a rather difficult predicament.

Here’s the current position for Sappi shareholders to ponder, probably despondently:

The group has returned to profitability but gearing remains extremely high – US$2,43bn at the end of its first financial quarter, to end-December 2010. Retiring debt will remain a priority, says CEO Ralph Boëttger. Sappi recently published a trading update on its debt refinancing and further loans, this time the main one being a $680m bond issue. Sappi is bringing down the high cost of its debt. That’s good. We’re still trying to work it out, but it seems Sappi is also increasing its net debt position.

But here we’re apparently wrong. André Oberholzer, Sappi group head of corporate affairs, says net debt won’t increase as a result of its debt restructuring. We’ll go into more detail on its complicated re-financing of debt later.

Despite that, Sappi is closing down paper mills in a deal we’ve always been critical of: namely, the €750m – nearly R9bn then – acquisition of four mills from Finland’s M-real two years ago. One has been closed, the Kangas mill in Finland, and the Biberist mill in Switzerland will also almost certainly be closed as well. That wipes out half an expensive investment it has had no return on. What was Sappi thinking at the time?

Among other things, that it would enable Sappi to take greater advantage of opportunities where markets are strong and reduce risk where they’re weak, it said. That didn’t happen and two of the mills, maybe all three still operating, aren’t generating acceptable returns. Was that worth €750m?

However, Oberholzer says since the acquisition “all of the mills have been cash generative. The economic downturn, very high pulp prices and continued overcapacity have had a particularly severe impact on our Kangas mill – which we’ve closed down – and forced us to consider the closure of our Biberist mill.”

Does “cash generative” mean the mills were paying a sufficient return on investment? If yes, why is Sappi raising new debt?

But if it looked like a “dud deal” – as Finweek called it in our cover story on 20 November 2008 – funding the deal was outrageous. It involved a €450m rights issue (about R5,8bn) pitched at an unbelievable 65,2% discount to Sappi’s then share price on the JSE of 5825c/share. Naturally, Sappi’s share price collapsed soon afterwards. At the time Boëttger said the rights issue was “economically neutral” for shareholders and would simply set a new trading band for Sappi shares at around 3600c. He was so right. The share is currently trading around that now: to be precise, at 3545c/share last Tuesday.

Institutional shareholders – led by then largest shareholder Allan Gray, with more than 25% of Sappi’s equity – should, in our opinion, have objected, but they didn’t. But they had to follow their rights.

That’s part two of why the rights issue was outrageous. Sappi, sort of casually, announced it would be issuing 286,9m new shares in its rights issue. The shock was it more than doubled Sappi’s 239m shares already in issue. So unless it wanted their shareholding diluted more than the British Queen’s occasional gin and tonic, we believe that institutional shareholders such as Allan Gray and RMB Asset Management, with around 8% of Sappi, had to follow their rights. However, Allan Gray disagrees with us. Allan Gray recommended investors also follow their rights. It has a lot to answer to for those investors who took its advice.

Delphine Govender, director and portfolio manager at Allan Gray, says with perfect hindsight things might have turned out differently. “But this was 2008, the European market had a considerable oversupply of coated paper production capacity. Something had to happen to improve pricing. After years of depressed industry returns, as the market leader, Sappi felt it had to do something.”

But was it worth following rights in a contentious rights issue? And not all the institutional shareholders followed their rights. SA’s Industrial Development Corporation, also a significant shareholder, abstained.

“It hasn’t been a great investment to date,” says Govender. “Allan Gray is holding on because we believe we can still get a return on the investment.” That’s the view from an institutional shareholder. Allan Gray is well known as a long-term investor. But what about those individual minority shareholders it recommended to follow their rights? “Following rights wasn’t a good decision based on the financial returns,” Govender says.

As it was, the rights offer was fully underwritten by international merchant bankers Citigroup and JPMorgan. Both aren’t very happy bankers now, but their undertakings secured the €450m Sappi was looking for from the rights issue.

But Sappi needed more to fund the M-real acquisition. So here’s part three of the outrageous funding story. Sappi took a €250m vendor’s loan from M-real, the group it was buying. Repayable over four years, interest on the loan began at 9%, increasing to 15%. In pre-financial crisis Western Europe, even today that’s very expensive debt. And guess who helped fund the high interest payments? Shareholders again.

However, Sappi got rid of that expensive debt quickly. “The vendor loan was settled in August 2009 at a discount of $41m (€30m) to the face value of the loan,” Oberholzer says.

One lone voice was questioning the deal and rights offer – well-known minority shareholder activist Theo Botha. He flooded Sappi with questions. We have the minutes of its 2008 AGM. But Botha’s main concern at the time was about disclosure. “They’re paying R9bn for a loss-making operation (M-real had been making losses for its previous two financial years), with the holding company having a market capitalisation of R5bn. Nowhere in the circular does it show how it arrived at the R9bn valuation of the business. They’re actually buying four mills – but there’s no valuation of the mills or information about them, like how old they are, what capacity they’re running at, are they environmentally friendly and how much capital expenditure will be needed on the mills,” Botha asked.

As it turned out, the M-real mills were pretty old. Sappi is blaming the almost certain closure of the Biberist mill on “tough market conditions, coupled with rising input costs”. Market conditions are always tough in Sappi’s main market in Western Europe. Rising input costs are an unfortunate reality. But older mills are less efficient and more expensive to run, the reason perhaps for the Biberist mill not being able “to generate acceptable returns”.

Boëttger said at the time of the rights issue it cost around €100m to close a mill. So €100m already gone, probably €200m to follow. That’s getting close to half of the €450m raised from its rights issue. To repeat what’s becoming a boring question, was it worth it for shareholders? We’re listening hard but can’t hear any shouts of “yes”.

“Return on investment in the four mills won’t be enough to repay the loans. After investing so much money, the South African company is left with the capacity problem in Western Europe,” says Botha. And he asks: “Which is the better company now? M-real is flying, it’s got rid of debt and its share price is up. Compare that to Sappi.”

Does that mean Sappi’s operations in SA, and in the United States, are subsidising the effects of the M-real deal?

“Not at all,” says Oberholzer. “Europe’s trading conditions have been tough but profitable and the business has generated strong cash – more than our US business. Indeed, the European business generated over half of the $600m net cash generated by the group over the past two years. Our European business has made a significant contribution to Sappi’s much improved performance over the past two years.”

Sappi’s cash generation is strong and so is its balance sheet. We understand and agree with refinancing debt to lower the overall interest rate. But why is Sappi taking out additional loans?

“We’re repaying $950m of debt maturing in the next year or so by using $150m of our own cash and the $705m proceeds of the seven- and 10-year bonds we issued last week,” says Oberholzer. “The refinancing improves our maturity profile dramatically, utilises $150m of our large cash holdings, lowers the overall cost of our debt and gives the group access to a five-year revolving credit facility of approximately $500m (€350m) should we need it. Moody’s sees the refinancing as positive and changed its outlook on our rating from stable to positive last week.”

However, Standard & Poor’s view is that refinancing through the $680m bond and €350m revolving credit facility increased the level of secured debt that ranks ahead of Sappi’s unsecured obligations. It accordingly lowered its issue ratings on Sappi’s unsecured debt to B from B+ and revised recovery ratings on the debt to six from five.

Standard & Poor’s revised ratings aren’t that significant but indicate some concern about Sappi’s high debt levels. While net debt at year-end 2010 was $2,43bn, we were told net debt “will not increase” as a result of the debt restructuring. But we weren’t given a new net debt number. However, Oberholzer says the average cost of Sappi’s net debt is between 8% and 10% “depending on the level of cash we hold; Libor/Euribor rates that impact our floating debt rate and rand/US dollar and euro/US dollar exchange rates, which impact our euro and rand debt when translated into our reporting currency, US dollars”.

That still looks like fairly expensive debt. And Sappi’s debt structure always seems very complicated, a symptom perhaps of operating in major global markets and translating everything back to US dollars. But readers can probably see why we found it difficult to work out if Sappi’s debt was increasing or not through its debt restructuring.

We also stick to our original view of two years ago: that the €450m rights issue was contentious for the reasons outlined above and that the M-real acquisition was a “dud deal”. Two years on and the closure of one and probably two of those M-real mills seems to support our view.

Oberholzer argues closing the mills due to continuing overcapacity “would have been of a different order of magnitude if the M-real deal didn’t take place. In addition, we achieved three consecutive price increases in 2010 – the first time that’s proven possible in seven years.”

Price increases can only get through – and stick – without losing market share or customers if capacity is reduced. So did Sappi buy the M-real mills to close them down?

“Sappi bought the M-real business to add value to our European operations and strengthen our market position. We understood all along the fact that over time further capacity closures would probably be required across our European asset park. The economic crisis – which became apparent only after the M-real deal was signed at end-September 2009 – has required quicker action, which we’ve taken as the clear market leader,” Oberholzer says.

But its M-real deal hasn’t added any value, at least so far, for minority shareholders who followed their rights in the rights issue two years ago. Measured by any means – return on investment, time value of money – where are they today? Sitting with shares at the same price as that after the rights issue. And no dividend payments.

Finweek was critical at the time. We wonder if any individual minority shareholders read our views and didn’t follow their rights.

MONDI

No urge to demerge

Mondi might do it, but not Sappi

Mondi [JSE:MND] – South Africa’s other paper and packaging group that operates mainly in the same Western European market as Sappi – is proposing corporate action Finweek suggested Sappi should follow two years ago. Mondi plans to demerge its South African packaging business and list it separately on the JSE, offering investors a choice of businesses to invest in.

The idea is that all the ordinary shares in Mondi Packaging South Africa (MPSA) held by Mondi Ltd, the JSE-listed part of the dual listed group, will be distributed to Mondi Ltd ordinary shareholders. Mondi owns 70% of MPSA, with the Shanduka Group holding 25% and the Mondi Employee Investment Company the rest. MPSA will then be listed under a new name on the JSE.

The reasoning behind the proposed demerger is that MPSA’s future growth plans, particularly in regard to its rigid plastics business, are constrained by Mondi Group’s differing strategic focus. The demerger would allow MPSA to follow its own strategy and provide shareholders with the benefit of both businesses being able to take better advantage of their respective growth opportunities.

“This is the right time to demerge MPSA – for both Mondi Group and MPSA,” says David Hathorn, CEO of the Mondi Group. “While Mondi Group has been a very supportive owner, this move will give MPSA the flexibility it needs to develop its core growth areas. MPSA is unique within the group, as no other part of Mondi produces rigid plastics or carton board and therefore the directors felt MPSA would be best placed to take advantage of the considerable opportunities available to it as an independent entity.”

The proposed demerger would require a “matching action” – under the group’s dual listed structure – to have “an equivalent but not necessarily identical economic effect” on the ordinary shareholders of London-listed Mondi plc.

Though on a much larger scale, Finweek suggested two years ago that Sappi should be split in two and be separately listed on the JSE. The idea was it could be divided into Sappi Southern Africa, where Sappi has substantial assets in factories and forests, and Sappi International, which would essentially contain its operations in Europe and the United States. Though Sappi’s earnings are notoriously cyclical, its South African business does tend to be more stable than those overseas, particularly Europe, where overcapacity, pricing and foreign currency fluctuations are all factors.

The move would offer investors the choice between investing in two fairly different businesses. It would also allow Sappi to undertake separate corporate actions, such as rights issues, depending on where the capital was needed.

But that’s not part of Sappi’s thinking. Its response to our question about whether it would consider a demerger was: “This is not under consideration.”

 
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